The euro currency’s recent decline against the dollar following the European Union’s failed Brussels summit and European voters’ rejection of the draft European constitution has brought some cheer for the German carmakers. The outlook for profits on US shipments is enhanced, especially in 2006 as hedging protection runs out. Neil Winton reports.
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Television news cameras were on hand to record the glum expressions on the faces of German Chancellor Gerhard Schroeder and French President Jacques Chirac, as they left the infamous Brussels summit with the European project, and the euro currency, collapsing around them.
But the cameras seem to have missed a rather different reaction in Wolfsburg, Stuttgart and Munich, where the leaders of the big German car exporters must have at least been looking smug, if they weren’t actually dancing in the streets.
One of the first reactions to the massive “No” votes in May to the European Constitution by the French and the Dutch was a fearsome tumble on foreign exchange markets by the euro against the dollar. At a stroke, the profit prospects in the U.S. of BMW, Volkswagen and to a lesser extent DaimlerChrysler, were transformed.
The failed summit in Brussels just underlined the point that the European project for an ever closer political union was on the rocks, and some investors fear that it will be joined by its iconic flagship, the euro single currency.
Foreign exchange markets were overwhelmed by frenzied investors who reckoned they saw the seeds of the euro’s destruction in the referendums in France and Germany, which showed that many citizens of Europe had soured on the idea of an ever closer political European Union. The failed summit maintained that impression.
Analysts agree that the euro’s slide is real, but they don’t expect the system itself to collapse.
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By GlobalDataInvestment banker Goldman Sachs, in a research report, slashed its prediction for the value of the euro against the dollar to $1.20 from $1.30, and raised its profit targets for BMW, VW, and DaimlerChrysler.
Profit estimates up
Goldman Sachs raised its net profit estimates for BMW by 50 million euros in 2005 and 334 million in 2006, DaimlerChrysler’s by 92 million and 413 million, and VW’s by 65 million and 320 million euros.
But Goldman Sachs wasn’t entirely sure that all problems were over for the Germans.
“The future profitability of the German exporters remains highly geared to the U.S. dollar and even small moves in the currency will have significant effects on earnings and cash generation. However while $1.20 is clearly better than $1.30, it is still a long way from the highly favourable rates seen back in 2001-2002, rates that were perpetuated for most German OEMs by hedging activities,” Goldman Sachs said.
“The current exchange rate remains a real challenge to the international competitiveness of the German car industry. On our estimates companies that are still enjoying hedging profits – notably BMW and Porsche – will still see earnings under pressure once these hedges expire,” according to Goldman.
Euro projections slashed
Morgan Stanley joined in the fun and slashed its predictions for the euro versus the dollar at the end of 2005 to $1.19 from its previous forecast of $1.26. The euro had hit a high of close to $1.37 at the end of 2004, and sank back to about $1.21 a couple of weeks after the votes in France and Holland.
According to Deutsche Bank, if the euro falls to $1.20 in 2006, compared with its recent assumption of $1.35, this would raise BMW net earnings by 19 per cent, Mercedes 17 per cent, and VW a whopping 30 per cent.
Citigroup Smith Barney said the euro’s fall “materially reduces foreign exchange headwinds (for German auto makers) particularly in 2006 when most of the auto makers’ hedges were running out.”
Citigroup was particularly excited by BMW’s prospects, which will be transformed by the dollar’s recovery.
“The recent U.S. dollar move to $1.24 is shaving up to 200 million euros off the potential foreign exchange headwinds (for 2006 and 2007). We also believe that the BMW system is able to absorb foreign exchange and raw material headwinds in 2005 and 2006 with operating leverage, purchasing savings, productivity gains and a touch of net pricing,” said Citigroup Smith Barney.
BMW margins recovering
Citigroup Smith Barney reckons that BMW’s underlying profit margins troughed at 5.3 per cent in 2004, and should move back up to more than 7 per cent by 2007.
Meanwhile, the Financial Times was reporting that Volkswagen was taking advantage of the euro’s slump to shore up its dollar financial hedging insurance by raising the level by five percentage points, bringing it to 75 per cent of dollar revenues. Last year VW lost close to 1 billion euros in the U.S., and was expected to lose a similar amount in 2005. VW is busily seeking natural protection against dollar fluctuations by moving more production to Mexico.
DaimlerChrysler told the FT that it takes the opportunity of currency rate changes to boost its hedging policy, but declined to confirm what action it may have taken.
Hedging top-up
Goldman Sachs agreed that Mercedes and VW had taken advantage of the euro’s drop to improve foreign exchange hedging protection.
“We understand that Mercedes is now around 80 per cent hedged for 2005 at an average rate near current spot ($1.22 on June 20). We believe VW has also increased its hedging for 2005 but it is unclear to what degree. The profit benefits of any further decline n the euro will depend on the flexibility of the hedging products purchased. BMW has had extensive hedging cover in place for 2005 for some time. But we understand that Mercedes, VW and BMW have only limited protection for future years – so the recent move in the dollar will reduce the pressure on the earnings of all three in 2006,” Goldman Sachs said.
Morgan Stanley tried to pour oil on the troubled waters churning around the euro’s future.
Euro will remain
“Leaving the euro is not an option for any of the members of the E.U.,” said Morgan Stanley’s Eric Chaney in a report.
Chaney said that if Germany decided to move back to the mark, the economy would be hit by deflation, as the wage bubble of the early 90s would compound a sharp appreciation of the currency.
“If Italy had not joined the euro, government debt would have continued to spiral up until a balance of payments crisis put Italy in the hands of the IMF. Leaving the euro today would leave no other option than defaulting on government debt, with chaotic consequences,” said Chaney.
“Wise investors should keep in mind that the euro area is unlikely to break up any time soon and should therefore refrain from playing extreme scenarios,” he said.
Dollar hegemony
Another Morgan Stanley analyst, Stephen Jen agreed that the euro zone was here to stay, but so was U.S. dollar hegemony.
“Five years after setting the goal (in Lisbon) to surpass the U.S. within a decade, both growth and level of income in Europe continue to lag hopelessly behind those of the U.S.,” Jen said.
Deutsche Bank though was anxious to point out that investors should be wary of this sudden development.
“While our currency strategists are still sceptical regarding the long term outlook for the dollar, the recent strength of the dollar should be a clear positive for the German car stocks. The fact that it had (a minimal) impact on the share prices is probably a reflection of a high degree of scepticism whether the recent strength is sustainable,” Deutsche Bank said.
Euro strength over
Goldman Sachs believed that caution was fine, but the euro’s strength was almost certainly a thing of the past.
“Altering earnings forecasts every time the currency moves could become tedious, but the move in the exchange rate seen over the last month (the euro is down 11 per cent from peak) appears more than a temporary aberration. The three large German exports remain highly sensitive to the dollar and we fee it is prudent to reflect the improved currency environment in our forecasts,” Goldman said.
But it too hedged its bets a little.
“Future moves in the exchange rate – in either direction – if sustained, will obviously require ongoing revisions.”
Neil Winton
